Question

Problem 6-6 Free Cash Flow Model (LO3, CFA2)

You are going to value Lauryn’s Doll Co. using the FCF model. After consulting various sources, you find that Lauryn's has a reported equity beta of 1.5, a debt-to-equity ratio of 0.5, and a tax rate of 40 percent. Assume a risk-free rate of 5 percent and a market risk premium of 8 percent. Lauryn’s Doll Co. had EBIT last year of $47 million, which is net of a depreciation expense of $4.7 million. In addition, Lauryn's made $7.25 million in capital expenditures and increased net working capital by $2.8 million. Assume the FCF is expected to grow at a rate of 4 percent into perpetuity. What is the value of the firm? (Do not round intermediate calculations. Enter your answer in millions rounded to 2 decimal places.)

Answer 1

Equity beta = 1.50

Debt equity ratio = 0.50

Unlevered beta of company is calculated below:

levered beta = beta (levered) × [1 + (1 - tax rate) x (Debt/Equity)]

                           = 1.50 × [1+ (1 – 40%) × 0.50)]

                           = 1.50 × [1+ 0.30]

                           = 1.95

Unlevered beta at tax rate of 40% is 1.95.

Now, Using Unlevered beta, cost of equity is calculated in excel and screen shot provided below:

Cost of equity = 5% + (8% × 1.95)

= 5% + 15.60%

= 20.60%

Levered cost of equity is 20.60%.

Weight of debt = 33.33%

Weight of equity = 66.67%

WACC is calculated below:

WACC = (66.67% × 20.60%) + (33.33% × 5%) × (1 - 40%)

= 13.73% + 1%

= 14.73%.

WACC of company is 14.73%.

Now,

Expected FCF = EBIT × (1 - tax rate) + Deprecition - Capex - Change in working capital

= $47 × (1 - 40%) + $4.70 - $7.25 - $2.80

= $28.20 + $4.70 - $10.05

= $22.85 million.

Expected Free cash flow is $22.85 million.

Value of firm = Expected FCF / (WACC - Growth rate)

= $22.85 / (14.73% - 4%)

= $22.85 / 10.73%

= $212.95 million.

Value of firm is $212.95 million.